The bigger picture of intermediation, financial crises

Source: The post is based on an article “The bigger picture of intermediation, financial crises” published in The Hindu on 17^th October 2022.

Syllabus: GS 3 – Economic Development

Relevance: findings of the Nobel Prize winner in economics

News:  This article highlights the role played by financial sector and banks in particular, in the development of modern economies.

Nobel Prize 2022 in economics has been awarded to Ben S. Bernanke, Douglas W. Diamond and Philip H. Dybvig for research on banks and financial crises.

What are the findings behind the Nobel prize in Economics 2022?

There are chances that banks may even fail in a stable condition. The reason given by them were the balance that bank has to maintain even in an ideal condition. That is, a bank has to turn short-term deposits into long-term lending.

Short term deposits are the deposits made by the people whereas long-term lending is given by banks in the form of loans.

Banks lend these deposits in the form of loans but there are instances of withdrawing those deposits by the depositors. It creates an imbalance.

However, unforeseen circumstances faced by the depositors (economic or political events of the nation) can make them feel uncertain of their deposits and can lead to withdrawal of the money.

This kind of situation will make banks to run out of the cash and it will affect their business.

Therefore, it is better to offer deposit insurance to the depositors to prevent such a crisis. This framework has been explained by Diamond and Dybvig.

They explained how financial development affects the rest of the economy and the effects of monetary policy on banks’ portfolio choices.